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## Investment Risk

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Investing

- Investing
- Definition of an investment: The current commitment of dollars for a period of time in order to get future payments
- Put in money today to get more in the future

Investing

- Risk -- Risk is the possibility that you won’t get back what you expect
- The problem with ignoring risk:
- Things sound too good
- Don’t consider the downside

Investment

- What are some investment options?
- Bank Account
- Bonds
- Stocks
- Real Estate
- Art
- Private Investment

How Risky are Investments

- Rank the following investments in terms of risk …
- An FDIC insured bank account
- An investment in the debt of Microsoft
- A 10-year government bond
- A friend wants you to invest in his idea to open a new barbershop
- A share of IBM stock
- Buying a house

How Risky are Investments

- Risk ranking…
- An FDIC insured bank account
- A 10-year government bond
- An investment in the debt of Microsoft
- Buying a house
- A share of IBM stock
- A friend wants you to invest in his idea to open a new barbershop
- http://www.finrafoundation.org/resources/education/modules/
- http://www.callan.com/research/periodic/

Investing

- Lesson:
- Higher risk, higher return
- Put money in a bank savings account, get 2% return guaranteed
- Put money in the stock market, get 11% with the chance that you may lose money

Compound Interest

- The principle of compounding means that you earn interest on interest
- Three things to consider
- Invest early
- Invest often
- Have patience

Risk

- How risky are you?
- You have the following choice for your salary in the first year that you graduate:
- $50,000 for certain
- A coin-flip where you get either $100,000 or $0

Probability

- What is more likely?
- Two people in this room have the same birthday
- Somebody in this room has a birthday on October 31
- Two people having the same birthday is actually much more likely
- You have to understand the role of probability in making investment decisions
- Relates to risk

Expected Returns

- Expected returns are based on the probabilities of possible outcomes
- In this context, “expected” means average if the process is repeated many times
- The “expected” return does not even have to be a possible return

Required Returns and Risk

- Suppose we have two assets, A and B, that are both expected to return 15% and have a price of $100. (thus, both stocks will return $15)
- Suppose that stock A is riskier than stock B.
- What would happen?
- What if the price of A fell to $75 and B rose to $150?

Required vs. Expected Returns

- Expected returns are what an investment will earn
- Required returns are what an investment should earn
- The two may differ, creating investment opportunities

Example: Expected Returns

- Suppose you have predicted the following returns for stocks C and T in three possible states of nature. What are the expected returns?
- State Probability C T
- Boom 0.3 0.15 0.25
- Normal 0.5 0.10 0.20
- Recession ??? 0.02 0.01
- RC = .3(.15) + .5(.10) + .2(.02) = .099 = 9.99%
- RT = .3(.25) + .5(.20) + .2(.01) = .177 = 17.7%

Variance and Standard Deviation

- Variance and standard deviation still measure the volatility of returns
- Using unequal probabilities for the entire range of possibilities
- Weighted average of squared deviations

Example: Variance and Standard Deviation

- Consider the previous example. What are the variance and standard deviation for each stock?
- Stock C
- 2 = .3(.15-.099)2 + .5(.1-.099)2 + .2(.02-.099)2 = .002029
- = .045
- Stock T
- 2 = .3(.25-.177)2 + .5(.2-.177)2 + .2(.01-.177)2 = .007441
- = .0863

Another Example

- Consider the following information:
- State Probability ABC, Inc.
- Boom .25 .15
- Normal .50 .08
- Slowdown .15 .04
- Recession .10 -.03
- What is the expected return?
- What is the variance?
- What is the standard deviation?

Portfolios

- A portfolio is a collection of assets
- An asset’s risk and return is important in how it affects the risk and return of the portfolio
- The risk-return trade-off for a portfolio is measured by the portfolio expected return and standard deviation, just as with individual assets

Example: Portfolio Weights

- Suppose you have $15,000 to invest and you have purchased securities in the following amounts. What are your portfolio weights in each security?
- $2000 of DCLK
- $3000 of KO
- $4000 of INTC
- $6000 of KEI

- DCLK: 2/15 = .133
- KO: 3/15 = .2
- INTC: 4/15 = .267
- KEI: 6/15 = .4

Portfolio Expected Returns

- The expected return of a portfolio is the weighted average of the expected returns for each asset in the portfolio
- You can also find the expected return by finding the portfolio return in each possible state and computing the expected value as we did with individual securities

Example: Expected Portfolio Returns

- Consider the portfolio weights computed previously. If the individual stocks have the following expected returns, what is the expected return for the portfolio?
- DCLK: 19.65%
- KO: 8.96%
- INTC: 9.67%
- KEI: 8.13%
- E(RP) = .133(19.65) + .2(8.96) + .167(9.67) + .4(8.13) = 9.27%

The Principle of Diversification

- Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns
- This reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another
- However, there is a minimum level of risk that cannot be diversified away and that is the systematic portion

Savings Game

- Start with $1,000
- You need to pick a risk category
- High risk earns 2X the market return, Medium risk earns the market return, Low risk earns ½ the market return.
- Market returns will be determined randomly.
- Each “round” represents 5 years. We will play four rounds.
- You can change your risk category after every round
- Goal is to end up with the most money at the end of the game.

Savings Game

- In addition to ending up with the most money you have to have:
- $500 at the end of round 2 to put a down payment on a car
- If you don’t meet the goal, you lose $1,000 on your ending total.

Round 1

- We will randomly choose a card from a deck of cards.
- Red means loss, black means gain
- Amount of gain/loss equal to the amount on the card, face cards all 10% gain/loss

Round 2

- If the market went up in Round 1, it is likely that the market will go down in Round 2.
- If the market went down in Round 1, it is likely that the market will go up in Round 2.
- I will now remove one suit (red or black) from the deck of cards and we will draw again.
- Remember
- You need $500 at the end of Round 2
- The probability of the market going up/down has changed. It is not random any more.

Round 3

- Risk aversion…choice of certain vs. uncertain payoff
- You can either go up 5%
- Risk doesn’t matter here. If you choose this you get 5%.
- I will flip a coin, heads the market goes up 10% tails the market goes down 5%.
- Risk matters if you take the gamble. High risk gets 2X market, medium risk gets market, low risk gets ½ market

Round 4

- Roll the Dice
- I will roll two dice…
- 5, 6, 7, 8, 9 the market goes up 10%
- 2, 3, 4, 10, 11, 12 the market goes down 5%
- Think about the odds, what is most likely to happen?
- Choose your risk level carefully this is the last round

External Resources

- http://www.financialliteracyfocus.org/edu.html
- http://www.mymoney.gov/myresources.html
- http://www.jumpstart.org/jump$tart-clearinghouse.html
- http://www.weseed.com/
- http://www.smartmoney.com/?link=SM_logo_home

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